Morningstar Magazine - August/September 2018 - 46

Strategies

Holding Bonds Under the New Tax Law
Investors should adopt a dynamic
location optimization strategy.

and may have additional negative financial
impacts because of decreasing medical expense
deductions, subjecting the taxpayer to the
Medicare surtax and increasing Medicare Part B
premiums. Thus, the federal tax rate on
bond interest can be as high as 43.575% (37% plus
3.8% plus 2.775% for the net medical expense
reduction), plus any Medicare premium increases.
Tax-Reduction Strategies

TAX WISE

Sheryl Rowling

Interest rates are going up, and tax rates
are going down. What does this mean for bond
investors? Should investors still own bonds?
And, if they do, how do the new tax laws affect
how and where they hold bonds? In this
column, I'll start with the basics and then move
on to strategies and recommendations.
Bond Basics

It's common knowledge that when interest rates
rise, bond values decline. So, in a time of
rising interest rates, many investors believe that
they shouldn't own bonds. This is not a good
decision for several reasons:
3 Bonds are negatively correlated to stocks.
3 The stability of interest payments can be a saving
grace in down equity markets.
3 If bonds are held to maturity, absent default, any
interim valuation losses are "illusory." 1
3 As long as bonds are not too far out in duration,
higher interest rates should not have a significant
impact on value.
3 As current bonds mature, new bonds will pay
a higher rate of interest.

A truly diversified portfolio will contain
various classes of bonds, including U.S. core
bonds, U.S. government bonds, mortgagebacked bonds, high-yield bonds, municipal

bonds, international bonds, and emergingmarkets bonds.
Each bond class carries different risk
characteristics, tax treatment, and return
expectations. Thus, tax considerations
must be viewed based on both common and
individualized aspects of each type of bond.
Bonds and the New Tax Laws

Although the Tax Cuts and Jobs Act of 2017
made significant changes to the tax laws,
the basic taxation of bonds remains unchanged:
Nonmuni interest is taxable as received
(or accrued-as in the case of zero-coupon bonds)
and gains and losses are recognized when
the bond is disposed of (or redeemed). Current tax
laws affect bondholders in the following ways:
3 Taxable interest is taxed at ordinary tax rates.
3 Taxable interest and capital gains may be
subject to the 3.8% Medicare surtax (depending
on income level).2
3 Taxable interest and capital gains are part of
adjusted gross income, which reduces deductibility
of medical expenses.
3 Taxable interest, capital gains, and taxexempt interest are part of modified adjusted
gross income, which, if in excess of
certain levels, can increase the cost of Medicare
Part B premiums. (See exhibit.)

The bottom line is that non-municipal-bond
interest is taxable annually at ordinary rates-

Managing investments at the household level
(across accounts) provides an opportunity
to create tax savings with location optimization
by holding specific types of investments
in different accounts to minimize tax costs. This
tax-aware strategy is typically based on
a static set of assumptions. After the new tax
act, there could be a case for a dynamic
location optimization.
Traditional location optimization organizes
accounts into three types: taxable accounts such
as joint accounts, trust accounts, and personal
accounts that are subject to tax as income
and gains are recognized; tax-deferred accounts
that will be subject to ordinary tax rates
as amounts are withdrawn, such as IRAs, SEPs,
401(k)s, other retirement accounts and annuities;
and tax-free accounts such as Roth IRAs.
In an established location optimization strategy,
investments are divvied up as follows:
3 Investments with the highest expected returns,
such as emerging-markets equities, should be held
in the Roth IRA. Because the Roth will likely
be the last resource tapped in retirement, it can
withstand volatility. And because the Roth
will never be taxed, higher-returning investments
will get the greatest benefit.
3 Investments that produce regular ordinary
income, such as taxable bonds, belong
in tax-deferred accounts. This defers tax on the
income. When the money is eventually

1 Value declines are meaningless unless bonds are sold before maturity. The investor will continue to receive interest payments (at lower than market rates) and will receive full face value
at maturity. This concept is often cited as a reason to invest in laddered bonds. However, if maturing bonds are continually replaced with new bonds, this strategy is essentially equivalent
to bond mutual funds.
2 The Medicare surtax applies when individuals have net investment income combined with modified adjusted gross income over the following thresholds: married filing jointly: $250,000;
married filing separately: $125,000; single: $200,000; head of household (with qualifying person): $200,000; qualifying widow(er) with dependent child: $250,000.

Morningstar August/September 2018

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2018